The New Audit Committee Religion

When U.S. Bancorp announced its second quarter earnings of $0.53, missing analysts` estimates by just a penny, the share price dropped about 4.5% in two days. That`s not the same kind of volatility experienced daily by high-tech investors, but it`s enough of a drop to make bank investors frown.

The rise of the Internet has made it possible for millions of investors, analysts, and journalists to react instantly to any news-positive or negative-about a company`s perceived financial stability, creating the basis for a more volatile market. This heightened sensitivity has made companies more aware than ever of the importance of reporting results that are consistent with the market`s expectations.

The motivation to satisfy Wall Street`s earnings expectations [is] beginning to override long-established precepts of financial reporting and ethical restraint, said SEC Chairman Arthur Levitt, in an October address at the Economic Club of New York.

Naturally, the board of directors, as well as management, is scrutinized when questions are raised about a company`s financial reporting. In particular, the audit committee, whose job is to monitor internal controls and risk management practices, has become a focus of intense investigation by regulators and shareholder activist groups.

Consistency in earnings is nearly imperative in today`s financial markets-a fact that has led directly to some companies` creative use of accounting rules. The hottest topic in director seminars these days is dealing with earnings management, says Roger Raber, president and CEO of the National Association of Corporate Directors (NACD). And you know what that is? That`s another name for cooking the books. In an April 1999 speech, SEC Commissioner Norman S. Johnson defined the term more prosaically: u00c3″Earnings management` refers to the practice of companies misapplying accounting principles in order to report artificially u00c3″smoothed` earnings.

Audit committees in the spotlight

Against a backdrop of corporate earnings blowups and accounting scandals, the normally inauspicious audit committee has been reluctantly ushered to center stage. The SEC`s growing attention to audit committees and their role in financial reporting led to the formation of the Blue Ribbon Committee on Improving the Effectiveness of Audit Committees (BRC) in September 1998. Shortly after, the 11-member panel then announced its 10 recommendations for audit committee best practices in February 1999.

The first two recommendations define and mandate independence for audit committee members. The third suggests that members be financially literate. The remaining seven deal with mechanisms for accountability and communication between the audit committee management and internal and external auditors, including recommendations that would require having a written charter for the audit committee; that the audit committee oversee quarterly reports; and that an audit committee report appear in the proxy statement.

Last October, the SEC proposed a five-part regulation titled Audit Committee Disclosure, drawing heavily from the recommendations of the Blue Ribbon Committee. On the same day, the New York Stock Exchange, the American Stock Exchange, and the National Association of Securities Dealers each issued their own proposed regulations based on the committee`s conclusions.

This initiative is based on a simple premise: Good corporate governance contributes to reliable financial reporting, said SEC Chairman Levitt in his October speech. The goal, he said, is to create informed and effective audit committees that can monitor the financial reporting process to prevent the types of u00c3″earnings management` and outright fraud that have caught the attention of our enforcement division.

I`d like to see whatever changes that take place do so by companies wanting to raise their standards of performance, says Raber. I have concerns when boards have to be told by a regulator: u00c3″You`ve got to do this.` I`m hoping that a number of companies will say, u00c3″Well, we`re already doing that, and even more.`

In a survey of 1,016 corporate directors conducted by executive search firm Korn/Ferry International, an overwhelming 96% of respondents felt that their audit committee was well enough informed about such audit-related issues as internal controls, financial reporting, and conflicts of interest. Even with this vote of confidence, directors believe there are measures audit committees can undertake to become even more effective. Fifty-eight percent of the respondents said the committee should receive more assistance from internal and outside auditors, while 49% believe there should be more specialized training for the audit committee chairman and its members.

Though boards may believe they already meet the standards outlined in the proposed guidelines, there are important issues about which all directors should be educated: director independence; director qualifications; and the mechanisms and procedures both for ensuring the audit committee`s accountability and for strengthening communication between the audit committee, management, and the external auditors.

Independence: a moving target

It is important to have directors who are independent of management and independent of the audit firm in any material way, asserts former SEC director Phil Lochner, who served as a director of Brooklyn Bancorp until it was sold to Republic New York Corp. in 1996 and now serves on the audit committees of two nonbank companies, Apria Health Care and Clarcor. Patrick Pope, chairman of the audit committee for Raleigh-based Triangle Bancorp, strongly believes that all audit committee members need to be independent of management in every respect. That`s the only way that it`ll work.

No one seriously disputes the idea that audit committee members need to be independent of management. The trick is deciding where to draw the line.

Some bankers believe that line has already been drawn for depository institutions. The function and independence of audit committees are areas that the bank regulators dealt with a long time ago, says Patty Meringer, corporate secretary for New Orleans-based Hibernia Corp. Indeed, the banking industry is so stringently regulated that many thorny issues relating to fiduciary duty have been smoothed out long ago. Meringer believes that additional regulations will muddy the waters at banks, rather than clear it. There is already a definition of independent directors in the tax laws for compensation committee members that works fairly well, she points out. And that one happens to be consistent with what the bank regulatory agencies have been using.

Korn/Ferry`s head of board services, Madeleine Condit, agrees that creating a new measuring stick for independence could be problematic for financial institutions. These proposed regulations weren`t targeted toward banks, and I would agree with those from the banking industry who say there is a potential for conflict, she says. Banks, for the most part, already have outside directors sitting on their audit committees. Says Tim Badger spokesperson for Glen Falls, New York-based Arrow Financial Corp.: We`ve always had an independent approach to the audit committee. All our directors are independent, and we don`t believe we`d need to make any changes. As Triangle Bancorp`s audit committee chairman, Pope meets with internal and external auditors on a regular basis and checks to make sure there isn`t a real cozy relationship developing between management and the external auditors. We`ve never had a problem, he states.

Hibernia Corp., on the other hand, doesn`t deny that several of its directors are affiliated with firms that are customers of the bank. In fact, it defends the practice. I don`t think you could find a group of directors at Hibernia that didn`t have a pretty close connection with the bank in one way or another, counters audit committee chairman William O`Malley, and I see that as a good thing, rather than a bad thing. Meringer agrees there are few other options. If we want to get business leaders and community leaders on our board, they`re going to be [our] customers. There`s just no way for us to get around that. And if we were to follow a rule that says u00c3″You can`t have any of your customers be on your board,` I don`t know where we`d be looking for board members, she says. We could go to Wall Street and find some people to sit on our board, but what do they know about banking in Louisiana?

Neither Meringer nor O`Malley believes that Hibernia`s directors` relationships with current customers, which aren`t significant enough to require disclosure in the annual proxy statement, have any material impact on board member`s decisions. Meringer further points out that a policy requiring absolute non-affiliation doesn`t necessarily guarantee independent thinking: There are lots of people who don`t have any relationship to a company who, nevertheless, would not act independently if they were put in a situation where the board had to disagree with management, or if they had a disagreement with their auditors.

Many corporate governance watchers-among them, pension funds and other shareholder activist groups-continue to favor tighter restrictions on the notion of independent directors. If anything, the NYSE proposed regulation is too weak, says director Lochner. An independent director has no substantial financial relationship to the organization, stresses the NACD`s Raber. You`re out there looking at what`s best for the company, regardless of its impact on you.

Audit committees need to document the independence of their members using a measure that is internally consistent as well as defensible (see sidebar page 32). Moreover, in such delicate matters it is often the perception of a conflict of interest, rather than its existence, that presents a problem. It is, therefore, in the audit committee`s best interests to be honest about the independence of its directors, to avoid the impression of keeping secrets. As a result of the renewed zeal over this issue, says Dan Doheny, a KPMG partner who leads the firm`s Audit Committee Institute, Most directors are taking a look at their independence, and some board members will most likely step down from audit committees because of potential perceived conflicts.

Financial literacy: setting standards

The second major factor directors should be evaluating is the qualifications needed to become effective audit committee members. The Blue Ribbon Committee`s third best practice recommends that audit committee members be financially literate, and the SEC and stock exchanges` proposed rules contain similar requirements.

Whereas the issue of director independence is complicated because there are so many different interpretations, the financial literacy requirement is so new that no regulatory body has established a concrete definition for it.

Financially literate? No one knows what that means, says Lochner. In some cases, having a director that has little financial background but can ask intelligent questions can be just as useful.

I don`t think there`s any company in the country that would tell you u00c3″We have people on our audit committee who would not pass the financial literacy test,` says Meringer. The question`s going to be, what are you using as a test, and who gets to second-guess whether your test is reasonable?

Clearly, if financial literacy is to become a requirement of audit committee members, some standard will need to be adopted. Boards should think about documenting the financial experience of their audit committees and actively promoting a corporate standard for such experience. A good-faith effort to establish proof of financial literacy, even before regulations or industry standards are adopted, goes a long way toward satisfying fiduciary duty. Of course, at banks, directors already are expected to know how to read an income statement and balance sheet.

The vast majority of our directors are either senior executives at very large companies or they`re CEOs of their own companies, says Meringer. If they don`t understand a financial statement, we`re all in big trouble.

For his part, Pope has advised Triangle Bancorp to create a seminar to acquaint new audit committee members with their enhanced responsibilities. He got the idea while serving on the board of trustees at a local hospital where new members were required to attend a three-night informal orientation session because of the sensitive and detailed nature of health care issues. If it works for a hospital, he reasoned, why not for a bank? After all, even directors with experience in other industries may need to be introduced to the particularities of banking. Pope recounts how a recently appointed member of Triangle`s audit committee had a wake-up call when she attended her first meeting. [She] is well versed in business matters, financial matters. She is the CEO of a telecommunications company that owns about 50 or 60 TV and radio stations-a real sharp businessperson. But when she sat down beside me at the first audit committee meeting, and when she saw the complexity of risk-based methodology, really, the only way I know how to describe it is that u00c3″deer in the headlights` look.

On the whole, directors shouldn`t be too anxious about the requirement to be financially literate, because chances are, they already are. When you read a lot of the documents on the enhanced importance of audit committees, it`s mind-boggling, because people think, u00c3″I have to be a full-time audit committee member, and I have to have an MBA in finance,` but no, you don`t, assures the NACD`s Raber. There are a lot of community banks that don`t have the resources of the GEs and General Motors of the world, that just need people who really understand balance sheets and financial statements and [can recognize] accounting irregularities.

Auditors, management, and the board:

a three-way dance

The third area that audit committee directors should work to improve is their relationship with management and auditors-and the mechanisms that strengthen information flow and accountability among all three parties. Directors will need to have increased communication with management and with the auditors, really trying to develop a very open, candid discussion, says Doheny.

O`Malley of Hibernia recommends that directors become very familiar with the external auditors. Make sure you have a feeling that the external auditors are not only doing their job and doing their job well but that there`s a clear sense of departure between what insiders are responsible for and what outsiders are responsible for.

Whether or not regulators will ultimately require audit committees to have charters or to include reports in company proxy statements, boards should consider whether these mechanisms are appropriate to their operations. Some observers fear that such requirements would lead banks to adopt boilerplate charters-being forever fearful of performing any function not strictly outlined. In any event, directors can help fulfill their fiduciary duty by encouraging independent strategic thinking on the part of audit committee members, questioning management and other board members when necessary, and documenting their own best practices.

In the end, fiduciary responsibility is something that is shared between management, the board, and the external auditors. Says Raber: You`ve got to know what questions to ask as an audit committee u00c3u2030 You have to make sure management provides you with the information, and they represent to you, the audit committee, the integrity of this information, and that the information given to you is appropriate.

Audit committees may be the subject of heightened scrutiny, but their underlying responsibilities have not changed. You still have the same fiduciary responsibilities you`ve always had. Every decision you make and every bit of information you hear, you need to assess in light of your responsibilities to the company and to the shareholders, says Meringer. You should not under any circumstances allow any rules about increased disclosure to cloud your judgment about what you think is the right thing to do.

For bank directors in particular, the new proposals do not present extreme pressure to change current practices. The layers of regulation already in place at depository institutions means that banks should have less trouble meeting any new requirements. Even so, for banks and nonbanks alike, defining and maintaining standards of independence, establishing open lines of communication, and documenting financial literacy are steps audit committee members should be taking already. Last, the proposed regulations shouldn`t scare competent directors away from serving on an audit committee.

The biggest concern I have is that people will take this material, or take the SEC regs, and say, u00c3″There`s no way I could serve on an audit committee.` I don`t think that`s the issue, Raber says. Rather, he`s optimistic: If you`ve got the right guidance and make sure you fully understand your role and the role of management, indeed you can do it. |BD|

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